Thu, Sep 19, 2019

The Unlikely Real Estate Investor

In the past three years, an unexpected type of market participant has evolved in UK commercial real estate investment – local authorities.
Download the Report

Read Upside - Autumn 2019

Outside of the real estate arena, this might surprise many, particularly in times of reported austerity, but local authorities have consistently spent, year-on-year, over £1.6bn on commercial real estate investments since 2016.1 This equates to almost £5bn over three years and is a significant increase from the £1.2bn spent between 2008–2015.

The reason for the increase in activity is simple – a relaxation in the Public Works Loan Board’s (PWLB) rules in April 2016 made it easier for local authorities to borrow from the Treasury at low rates to buy income-producing assets. The spread between the loan rate (typically 2-2.5%) and the return rate on the rental income governs the profit made by the local authority to then spend on local services.2

Of course, local authorities notoriously used a not too dissimilar strategy when they placed substantial sums on deposit with Icelandic Banks, with the deposits yielding attractive interest rates creating a spread between the interest income and interest on borrowing commitments. After Iceland’s banking sector collapse it took several years for these deposits to be recouped.

Driven by the desire to acquire income producing real estate, many local authorities have purchased assets outside of their administrative boundary. For example, Broxbourne Council (Hertfordshire) spent £17.2m on a Tesco investment in Grimsby and Bracknell Council (Berkshire) bought a £12.2m retail park in Lincolnshire.

However, there appears to be a renewed focus on acquisitions within administrative boundaries, with two significant purchases reported in August 2019 by Wokingham Borough Council (Twyford Waitrose for £14.87m) and Cambridge County Council (Cambridge Tesco for £51.4m).4,5

It is notable that Spelthorne Council is one of the most active participants, currently responsible for £1bn in loans from the Treasury having also made the well-publicised purchase of BP’s office complex in Surrey for £358.5m two years ago. Whilst there have been reports that Spelthorne may have “overvalued” investments, these have since been rebuffed by the Council and, subsequently, it has been reported that Spelthorne Council has changed its strategic focus to affordable housing.6 Nevertheless, there are very serious questions around how local authorities assemble a diverse and diluted portfolio, which spreads risk and income.

As a result, in April 2018, the UK Government instructed councils to take extra care over investments, particularly given the recent wealth of store closures in the retail sector and because of this, the nature of investment has somewhat shifted. For example, spending on retail assets fell by 34% in 2018 (to just over £400m), while the amount spent on office assets rose 23%, to a record £970m.7

Fundamentally, one must query the ability of local authorities to diligently asset manage these acquisitions noting the scale and complexity of their real estate investments going forward. While some will be more straightforward investments with a collectable rent roll year-on-year and no active asset management obligations until lease expiry (10-20 years), others may not be so straightforward. Equally, in instances in which tenants fail to meet their obligations, will these new owners be equipped to practically and proactively deal with the assets to avoid value and income erosion?

There is also the question of long-term plans when, for example, tenants vacate at the end of lease terms or exercise break options. While the investments may seem promising at this point in time – particularly for fully let, new buildings – they could be a resource drain in the future. Inevitably there will be some failed investments, raising questions of the investment decisions made during this cycle, and how this then impacts PWLB borrowing plus, of course, how local authorities will repay these interest-only loans without a need for a sale of the property assets at a future point in time.

Furthermore, there is also the question of pricing and whether local authorities are paying market value to secure these assets. While other investors may only be able to seek a portion of debt on market-facing terms, local authorities are arguably in an advantageous position relative to the general market due to the attractive pricing and structure of the PWLB terms. This means they can potentially pay more and may compete against each other when acquiring assets "off patch," driving the price higher. With this in mind, it should also be considered whether these values can be achieved again should these assets need to be liquidated due to a change in strategy or wider pressures. Time will tell.


Real Estate Advisory Group

Leading provider of real estate valuation and consulting for investments and transactions.